Economists argue that environmental assets, because
they are free or underpriced, tend to be overused or abused, thereby resulting
in environmental damage. Economic incentives seek to correct this situation by
setting a price for environmental damage or creating ownership rights to environmental
goods.

Some environmental resourcessuch as timber, fish and
mineralsare bought and sold in the market. But their price usually does
not reflect the true cost of obtaining them because it does not include the
cost of the environmental damage that may ensue from their extraction and processing.
Other environmental resources such as the atmosphere and waterways are public
or social goods that are not individually owned, or bought and sold, and do
not have a market price. Economists argue that there is a strong tendency for
people to overexploit and degrade these common property resources.

When individuals or firms make decisions about production,
consumption and investment, they generally do not consider the environmental
or social consequences because they seldom have to pay the cost of those consequences.
For example, a company that discharges its effluent into a river affects fishers
and other users of the water downstream. Yet the costs suffered by downstream
users are not charged to the company nor built into the price of the company's
products. The market does not take account of these environmental costs and
they do not appear in the companys account books. These spillover
effects of doing business have been called externalities by
economists, indicating that they are external to normal market transactions.

The presence of these externalities represent a failure of
the market to protect the environment. Economists seek to address this market
failure by adjusting prices so that the person buying the goods or services
causing the external cost is obliged to pay for it. This can be done by means
of a taxfor example, on coal mining to cover the medical expenses of those
miners who are suffering from black lung disease. The additional costs may also
provide an incentive to the coal industry to find ways to prevent miners from
getting this disease.

There are other ways of internalising environmental costs
without relying on the pricing mechanism. One example is to require a company
to take its water downstream from its discharge point. Laws force the polluter
to take notice of external costs by prescribing limits to what can be discharged
or emitted. Legislation can also cause costs to be internalised if it forces
companies to pay for cleaning up their wastes.

Economists argue that this could be done more effectively if
people and firms were charged real prices for using the environment. Economic
instruments aim to make these external costs part of the polluters decision,
by adding a charge or by in some way providing a monetary incentive for considering
the environmental and social costs. This ensures that environmental considerations
are incorporated into market decisions.

While legislation is aimed at directly changing the behaviour
of polluters by outlawing or limiting certain practices, economic instruments
aim to make environmentally damaging behaviour cost more. Under these market-based
policies, polluters are not told what to do; rather, they find it expensive
to continue in their old ways and they are presented with a choice about how
they can change. Usually, economic instruments are used in conjunction with
legal measures.

The Commonwealth Government identifies two main types of economic
instruments for providing an incentive to use resources sustainably:

Price-based measures use charges and subsidies to internalise environmental
costs and benefits.

Rights-based measures create rights to use environmental resources,
or to pollute the environment, up to a pre-determined limit, and allowing
these rights to be traded.

Price-based Measures

Not all pricing and taxation measures employed by the government
are aimed at environmental protection. They may also be used to promote other
goals and may have an unintended impact on the environment. However price-based
measures aimed at protecting the environment are referred to as economic instruments.
They include:

Subsidies and bounties

Subsidies are payments from the government to the producer
which effectively reduce the price of goods or services, and therefore encourage
their sale. Subsidies include tax deductions and rebates. A similar device is
a bounty that is paid to the producer for the goods produced (rather than one
that is paid when goods and services are bought).

For example, some tax-deductible activitiesfor money
spent on soil conservation, recycling schemes or for donations to environmental
groupsare aimed at encouraging environmentally beneficial behaviour. The
government can also provide grants for particular programs and projects, including
environmental projects such as the National Soil Conservation Program. Another
example is grants for environmental technology.

Charges

A charge can be considered as a price that is paid
for polluting the environment. Charges include:

effluent charges, that are based on the content and quantity of a firms
discharges into the air, water, or sewerage system;

user charges that are charged for using a resource such as timber or for
being provided with a service such as garbage collection;

product charges, for example charges on packaging that are used to discourage
disposal or encourage recycling;

The most well-known deposit-refund system is that used for
soft-drink bottles. This traditional mechanism for encouraging people to return
bottles for recycling has largely disappeared, although it is still used in
South Australia, and environmental groups such as Friends of the Earth are lobbying
for it to be reintroduced into other Australian states. Basically, with such
a system, a potentially polluting product is given a price that includes an
amount which is refundable if it is returned.

Rights-based Measures

Some economists argue that environmental degradation occurs
because of incomplete ownership of rights to use valuable resources. In situations
where the environment cannot be privately owned, access rights or user rights
can be owned. The idea of rights-based measures is that if people have a right
to the use or pollution of natural resources, they will consider the longer
term and manage those resources sustainably. The idea is also to create markets
so that the power of the market can be harnessed to environmental goals',
and individuals or firms can then use their superior knowledge of their own
activities to choose the best way of meeting environmental standards.

Tradeable pollution rights (Emissions Trading)

Tradeable pollution rights are an alternative to pollution
charges which allow firms to trade the right to emit specific pollutants. The
idea is that some firms can reduce their pollution more cheaply than others.
Those firms that can most afford to reduce their emissions are able to sell
their excess rights or permits to those companies that find it expensive to
reduce their emissions.

The two main ways of initially allocating tradeable pollution
rights are usually referred to as grandfathering and auctioning. Grandfathering
involves allocating permits to firms on the basis of their past emissions. Firms
that polluted more in the past would have larger shares. Alternatively a prespecified
number of pollution allowances can be auctioned off to polluters. In either
case the total allocation can be based on the estimated capacity of the environment
to take a certain amount of pollution.

If the permit that a company is allocated or has bought is
less than their actual emissions then such firms would have to either try and
reduce their emissions or buy extra permits. Similarly they would be able to
sell those they dont need if they reduce their emissions below what they
are permitted to emit.

Problems

Grandfathering favours existing firms and disadvantages new
firms wanting to set up. In order to establish itself, a new firm must buy up
enough pollution rights to cover its emissions. Ironically, it is often easier
and cheaper to install clean technology processes when a firm is newly established
than to refit an older established firm that has outdated and polluting equipment.
Alternatively the government can increase the amount of rights available and
give the new firm an allocation. This latter option will increase the amount
of pollution and defeat the purpose of trying to reduce overall emissions.

Auctioning means that each firm has to bear additional costs
just to operate as they have to buy permits at auction to emit gases they had
previously been emitting for nothing. This is especially hard for firms that
are competing with overseas firms not having to bear these costs. It is for
these reasons that auctioning appears to be less acceptable to industry, than
grandfathering.

A major drawback of emissions trading is that it can cause
some neighbourhoods to get a lot of more pollution than others because the companies
in their area are buying up permits rather than reducing their pollution. Also
emissions trading tends to protect very polluting or dirty industries by allowing
them to buy emission rights rather than meet environmental standards. In this
way, trading can reduce the pressure on companies to reduce their emissions,
for example by changing their production processes.

Some environmentalists argue that it is preferable in the long
run for firms that cannot make the environmental grade to go out of business
and make way for other firms that can produce substitute products in a cleaner
way. Opponents also argue that emissions trading sends the wrong signals. It
sends the message that it is the polluters who should decide what trade-offs
should be made between economics and environmental quality.

Theory vs Reality

The evidence of how well tradeable pollution rights have worked in practice
is mixed. Whilst proponents claim that a given environmental standard can be
met for much less cost, opponents argue that the environment benefits little
from such schemes. For example in Los Angeles there are two schemes to improve
air quality. One is the Regional Clean Air Incentives Market, RECLAIM, which
enables the trading of smog causing nitrogen oxides and sulphur oxides. An internal
audit by the South Coast Air Quality Management District found no significant
emissions reductions between 1993 and 1997 when the audit was done. James Jenal
from Citizens for a Better Environment claims this happened because companies
were able to inflate the baseline of allowable emissions, enabling an additional
40,000 tons of air pollution which would not have been allowed under the previous
regulatory regime.

The second scheme introduced in Los Angeles, was a trading scheme enabling
companies to offset their emissions by scrapping cars, that is, removing older
more polluting cars from the roads. Some twenty thousand cars were scrapped
in this way, but critics argue that these cars were often barely running and
would not have continued to be used much longer anyway.

The introduction of emissions trading as a mechanism for greenhouse gas reductions
has the potential to enable similar "phony" reductions. The most obvious
is the trading of emissions credits with Russia and other eastern European countries
that are in economic decline. Russias economic decline has meant that
its carbon dioxide emissions have decreased by some 30% below 1990 levels. Now
countries such as the US and Japan are looking to buy the right to those emissions
which Russia is unable to use so that they dont have to reduce their own
emissions. This will not benefit the environment or help to reduce the global
emissions of greenhouse gases in the long-term because the reductions that would
have occurred without emissions trading are now being used by affluent countries
to avoid their own emissions reductions. They are referred to as "hot air"
or "phantom" emissions reductions.

In the case of price-based measures, their effectiveness will
depend on whether the prices or charges are high enough. The OECD has found
that, in most countries, charges are too low to provide an incentive; instead,
they merely act to redistribute money from the polluter to the government. Governments
can use the money raised in this way for environmental protection, such as collective
treatment and research into pollution control technologies; but often they do
not.